Photochannel PNWIF
January 15, 2007 - 3:24pm EST by
issambres839
2007 2008
Price: 3.10 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 95 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

With its existing customer base, tiny Photochannel has the opportunity to make $124 million in annual revenue and could earn close to $2 in EPS annually. Further, there is an opportunity to get an additional large client, Costco in the U.S., which could get them another $1 a share in earnings. With a comparable trading for 70 times earnings and Photochannel experiencing triple digit revenue and earnings growth, Photochannel is a steal at eight times my 2008 estimate, and 15-20 times my 2007 estimate. Within two years, Photochannel has a shot at trading for $20 a share, making it one of the best risk/reward potentials I’ve come across in a long time.

What does Photochannel do?
 
Photochannel manages the front and back end of a retailer’s photo processing website. They are basically a private label version of Shutterfly (NASDAQ: SFLY). Using the example of CVS (NYSE: CVS), a consumer will go to CVS.com and then choose photo, then “Get started.” Photochannel takes over from there and handles all of the uploading and storage of pictures, then forwards those pictures in the right format to that customer’s local CVS and in one hour those digital pictures are ready to be picked up by the customer. It is important to make the specific distinction of what Photochannel does. They do not own the equipment in the retailer such as CVS. They only help process, store and send the photos as consumers upload the photos to the retailer’s website. They also handle email lists and email marketing functions for their customers as well as it relates to photos.
 
Their customer list is pretty impressive for a Canadian microcap company:
 
1) Wal-mart Canada
2) Costco Canada
3) CVS (U.S.)
4) Black’s (Canada)
5) Kmart (U.S.)
6) Eckerd’s (U.S.)
 
Photochannel provides the same web/photoprocessing service for all of these clients.
 
How Photochannel gets paid
 
Their payment varies depending on the size and type of photo, but the average is 2 cents for your average 4 X 6 photo that sells for 19 cents to the consumer. Photochannel is basically getting 10% of the gross proceeds for use of their technology and service. The bigger the picture the more money Photochannel gets. A rough rule of thumb is 10% of the gross payment.
 
The only place where this rule is not the case is on gifting items. Gifting items are personalized mugs and calendars with your own pictures on them. These items normally cost anywhere from $10 to $20, and Photochannel gets only 5% of gifting items or anywhere from $0.50 to $1 a pop.
 
Gift items are actually a growing element in photo processing. As consumers are finding out what they can do with their digital pictures, they are buying more and more of these personalized gifts. What grandparent wouldn’t want a mug with a picture of their grandkids?
 
Consumer education dealing with online uploading will drive revenue and earnings
 
Right now anywhere from 50-60% of all photo processing is for digital photographs. Of this amount most retailers have a very tiny percentage that is currently processing digital pictures online. That means that a vast majority of those processing digital pictures are trudging into the store, waiting in line and working with machines and staff to get the pictures uploaded. This is a complete waste of time. It is simply much easier to upload pictures from your computer, where your pictures are most likely stored anyway.
 
The retailers are now starting to gear up and educate consumers to do their uploading of pictures online for a variety of reasons. Online delivery makes the process much, much easier and allows the retailer to process more pictures as employees aren’t involved as much in customer service. Also with the convenience and ease of the online service, it puts retailers in a much better competitive standpoint to online alternatives such as Ofoto (owned by Kodak, NYSE: EK) and Shutterfly (NASDAQ: SFLY). With those alternatives you have to wait for the photos to be mailed to you and you have shipping and handling charges. With Photochannel and its retailer network, when you upload your pictures, they are done for you in one hour, and there are no additional costs.
 
Retailers are starting to advertise both in the store and on their websites to drive consumers to change to online processing of photos. Walmart.com typifies what is going on and how growth is exploding for online photo processing. Walmart.com told Thinkequity analysts that they expect triple digit annualized growth in online delivery of photos for at least the next three years. Photochannel saw 150% increase in photo processing from Walmart.com in Canada in 2006 over 2005. And Photochannel doesn’t see this triple digit growth stopping. Why? Because in 2006 only 6-8% of all of Walmart Canada customers uploaded photos in 2006. There is simply a lot of growth ahead and it could accelerate even faster.
 
Potential Revenue for Photochannel with existing customer base
 
If you were to look at a static picture based upon the last twelve month’s revenue and balance sheet or even calendar year ending 2006 numbers, you would think this is just another outrageously priced stock. I estimate that 2006 will see about C$5-6 million in revenue for the whole year. With about 31 million shares outstanding and about a C$3.50 stock price, Photochannel trades for about 20 times revenue!
 
But here is the rub, Photochannel has enormous revenue opportunity and its revenue should grow triple digits the next few years. It is much easier to understand by breaking down each client and looking what should Photochannel’s take should be.
 
Customers:
% of mkt
CAD$ amount
Dig
online 06
$ amount
Wal-mart Canada
30%
 $  300,000,000
50%
7%
 $  21,000,000
Costco Canada
22-25%
 $  225,000,000
50%
3%
 $    6,750,000
CVS (U.S.)
10%
 $1,180,000,000
50%
1%
 $  11,800,000
Black's (Canada)
6%
 $    60,000,000
50%
15%
 $    9,000,000
Kmart (U.S.)
2-3%
 $  295,000,000
50%
0%
 $                 -  
 
A couple of notes should come first. The U.S. photofinishing market is about USD$10 billion and the Canadian market is about C$1 billion.
 
Photochannel’s five customers represent more than C$2 billion in photo processing. At least 50% of this amount is digital pictures, or C$1 billion. Of C$1 billion in digital photo processing, only about C$50 million is delivered online. This obviously represents consumer ignorance. You can easily create a spreadsheet to estimate what % will eventually be digital and how many will upload online.
 
In three years, digital photo processing will probably be 80% of the market. And it is not hard to imagine that 75% of that 80% will be delivered online. My estimate is that 60% of all photo processing will be digital and will be uploaded online. I don’t think that is an aggressive estimate. This means that Photochannel’s existing customers alone will be doing C$1.236 billion in online photo processing. A very rough 10% estimate of that produces $123.6 million in annual revenue to Photochannel.
 
90% Gross Margins and Expense and capex requirements small, Cash machine
 
The real beauty of Photochannel is its gross margins of 90%. Further, it doesn’t take much in G&A expense to ramp up what the company processes. There is not too much sales expense, because of its small customer base. Basically, Photochannel is at the breakeven point right now and all additional growth will flow right to the bottom line. In short, Photochannel is about to turn into a cash machine.
 
Just to show you the upside. Let’s assume that my above revenue scenario comes to pass in three years. I estimate that the company would earn close to $2 a share in after tax earnings with C$123 million in revenue.
 
Conservative estimates
 
However, the potential may be, let’s try to be conservative. I estimate the following:
 
CAD
%
Photo's
%
Photo's
%
Photo's
Customers:
online 07
take
online 08
take
online 09
take
Wal-mart Canada
13%
 $ 3,900,000
25%
 $ 7,500,000
48%
 $14,400,000
Costco Canada
7%
 $ 1,575,000
14%
 $ 3,150,000
28%
 $  6,300,000
CVS (U.S.)
5%
 $ 5,900,000
10%
 $11,800,000
20%
 $23,600,000
Black's (Canada)
30%
 $ 1,800,000
45%
 $ 2,700,000
60%
 $  3,600,000
Kmart (U.S.)
2%
 $    590,000
5%
 $ 1,475,000
10%
 $  2,950,000
Eckerd's (U.S.)
 
 
 
 
 
 
Total revenue
 
 $13,765,000
 
 $26,625,000
 
 $50,850,000
 
These are rough estimates, but the important number is the % of photofinishing that each retailer does online. Using Walmart.com’s guidance and Photochannel’s current expectations and guidance, each customer should grow about 100%. I believe these percentages to be very conservative. Online should be a much higher percentage much sooner.
 
Here are my rough earnings estimates for Photochannel:
 
 
2006
2007
 
2008
2009
Estimates
 
 
 
 
 
Revenue
 $5,445,000
 $   13,765,000
 
 $      26,625,000
 $  45,765,000
Expenses
 $6,700,000
 $     6,700,000
 
 $        7,370,000
 $    8,475,500
Pre-tax earnings
 
 $     7,065,000
 
 $      19,255,000
 $  37,289,500
 
 
 $              0.22
 
 $                 0.57
 $             1.07
Shares outstanding
30,500,000
31,500,000
 
34000000
35000000
 
These are pre-tax numbers because Photochannel has substantial NOLs, and they should be able use them through 2008. In 2009, they will probably have to start paying taxes. Regardless, this stock is so cheap, make them fully taxed now and its still a low valuation.
 
Comparables and competitors
 
There are two comparables to Photochannel: Shutterfly and Snapfish. Shutterfly is public and has a market cap over $300 million, trades near $14 a share and is expected to earn $0.18 in 2007. Shutterfly trades for more than 75 times this year’s estimates. Now it is important to note that Shutterfly has a slightly different model. Whereas Photochannel is a private label company, Shutterfly operates a business to consumer model of its own brand. Shutterfly operates all of the storage and photo management as well as prints out the pictures itself.
 
The other comparable, probably more comparable, is Snapfish, which is private. Snapfish was bought out 18 months ago by Hewlett Packard for $180 million. I’m pretty sure that Snapfish had Photochannel type revenues 18 months ago.
 
Valuation upside is multiples of current stock price
 
Photochannel has so much upside that many things could go wrong and investors could still make money at current prices. Consider if Photochannel only had CVS as a customer. If eventually only 30% of CVS’ customers go online to process their digital photos, I estimate that Photochannel would earn after tax over C$0.40 a share just from CVS!
 
At a minimum, I think by year’s end they should trade at 15 times my estimate of C$0.57 in 2008, which would give you a price of C$8.55, or $7.25 in the U.S. Obviously, it could trade for much more. In fact, with triple digit earnings growth expected for the next three years, it could easily trade at 30 times earnings or C$17 a share. But there is much more that could drive the upside even higher.
 
Kmart, Costco and Rite Aid
 
Kmart is a client. Photochannel just hasn’t officially announced it yet. It seems Kmart was so anxious for customers to be able to upload pictures online that they rushed Photochannel’s service out before the official contract was signed. But you can see for yourself, by going to Kmart’s website and seeing that the photo processing goes through “pnimedia” wesbites, which is Photochannel. In talking with Photochannel, expect to see a press release any day.
 
Photochannel has Costco Canada, and there is a very real possibility that Costco (NASDAQ: COST) in the U.S. comes up for bid as early as March. Costco currently uses Snapfish in the U.S. and word is they may not be happy with Snapfish’s service and responsiveness. Costco may be interested in offering a “global” solution for both Canada and the U.S. and this may make Photochannel more appealing, as the company currently services customers in Canada and the U.S. Costco U.S. does about the same in photofinishing as CVS ($1 billion), which makes them a whale of potential client. Let’s just say that if Photochannel gets Costco as a client, the stock could easily double.
 
Another near term opportunity is to get Rite Aid (NYSE: RAD) as a client. Rite Aid does about $50 million in photo processing a year. Not a large client, but with the potential to make a couple of more million dollars at 90% gross margin, every client is a value booster.
 
CD burning, DVDs and more opportunity in the future
 
There is actually more to the Photochannel story than just photos. The company is testing a project to roll out an online CD making service. The idea is that a consumer would go online to walmart.com, pick 10-15 songs that they really love, pay $0.99 a song, then pay an extra $2.99 and then go to their local Wal-Mart and pick up their own personal CD with a jewel case and a nicely printed song list. This music service would use Photochanel’s technology and service similar to its photo division to direct the order to the correct store.
 
I think this type of service could be an innovative niche offering, especially as a gifting option. Photochannel is only spending $400K on developing this, so if it fails, there is no big financial fallout.
 
This music service would not be exclusive to Wal-Mart and opens Photochannel to other potential retailers and clients. Imagine if Starbucks (NASDAQ: SBUX) offered an option for customers to do the same thing but at every Starbucks.
 
Further down the road is the opportunity to offer a DVD service, in which customers go online and pick what DVD they want to buy and then walk into the local Wal-Mart and have their own DVD burned. Retailers would love this as it would mean they would only have to hold minimal inventory, but could make any DVD for anyone and only keep blank DVDs in inventory.
 
There is clearly more than just photos to Photochannel and the company is not sitting still.
 
High Quality management from Kodak
 
Insiders are heavy owners of the company, collectively owning more than 20% of the company. Further, the company has financed itself in recent years with strong participation from friends and family of the owners. Management clearly has skin in the game.
 
Management, especially the CEO, have excellent credentials. The CEO, Peter Fitzgerald, was a one of the top executives at Eastman Kodak (NYSE: EK). Mr. Fitzgerald was CEO of Qualex, Kodak’s photo processing division. His resume gives me a lot of confidence towards Photochannel being managed properly. He has run much bigger companies than this one.
 
Summary
 
With no analysts, no coverage and no exposure, Photochannel represents a rare opportunity to invest in a dot com with triple digit growth rates at 8 times next year’s earnings. There is a good chance that with a few more customers and things going as planned, Photochannel could trade over $20 a share, or 5 to 6 times higher than its current price.

Catalyst

-Kmart announcement
-Earnings announcements
-Music initiative with Wal-Mart
-New Client wins
-Possibly NASDAQ listing
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